“What is the primary reason to issue stock?” is a question we received last week from a customer and going along with our theme of publicly answering customer and webinar questions, we now bring you the topic of IPO‘s. With Snap (it calls itself a camera company?) going public last week, many are interested in some of the reasons why a company would do this. While there are many obvious answers to this such a raising capital, there are equally as many answers that are not so obvious to people but will make a lot of sense.
Without further ado, here is our answer to the question of “what is the primary reason to issue stock?”.
What Happens When a Company Goes Public?
Congratulations to all of those who owned Snap stock before the IPO as they were handsomely rewarded. But let’s jump right in…shall we?
When a company goes public, and let’s use Snap as an example since it is the bell of the ball lately, the first time it issues stock publically is known as the Initial Public Offering. The company decides how many of it’s privately held shares to sell on the public market for the first time.
When a company sells their shares on the public market they are doing the obvious. They are giving up equity in the company in exchange for cash payments at the fair market value. What that means is that people who buy shares of stock on the public market are buying equity (but not always voting shares) in the company. So when Snap sells it shares to the public for the first time, they are selling equity in their company.
Why Would a Company Want to Give Up Equity?
Well, there are a few obvious and not so obvious reasons for this. Let’s start with the obvious ones.
A company could issue stock to raise cash. Remember, when we buy shares from a company in exchange for equity we do it for cash. There are a lot of private companies who no longer have access to private capital or are profitable and issuing shares is a way to get public capital to fund day to day operations or expand the business.
At the same time, a company might issue shares because they have more than 500 private shareholders. Once a private company has more than 500 private shareholders, it must begin with the process of going public. This is a way our government forces the hand of these company to go public.
These are examples of the obvious reasons accepted by the public. Now on to the not so obvious reasons:
The first not so obvious reason is because the founders do not have a better way to liquidate their holdings in the company. If they cannot get additional private funding (such as venture money) or find a buyer on the private market, they can turn to moms and pops on the public markets who love IPO’s. Even better, these founders can make the IPO effectively only sell their specific shares. This guarantees that any shares sold on the IPO will allow the founders the specifically cash out before anyone else can.
Another not so obvious reason is because it is a very lucrative move. When companies now-a-days go public, they do not float all of their shares onto the public markets all at once. They sell 5% at a time.
The result of this? The insiders and investment bankers make a killing. Why? Because they own the overwhelming majority of the shares. And because they are issuing very tiny percentages of shares at a time, there is not enough stock available to borrow or short. This means that it takes months for a large enough amount of shares to be publically available for people to borrow and short. This also means that until that time, the only options for investors are buy to open and sell to close.
What is the Primary Reason to Issue Stock?
To wrap up…here are the obvious reasons:
- To raise capital
- Because they have more than 500 shareholders
- To allow the public to be owners of the company
and the not so obvious:
- To provide a liquidation event for the founders
- To make the founders and the bankers rich
So if I had to give an answer to the question “What is the primary reason to issue stock?” in one sentence I would say the following:
To make the founders and the investment bankers rich and dump the stock on the retail investors.